Defective IPOs: The Hontex Case Study

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Some weeks ago, I blogged about “The Lost Art of IPO Due Diligence”: See https://jlpwneedlawyer.wordpress.com/2018/07/19/the-lost-art-of-ipo-due-diligence/

To learn about undertaking proper IPO Due Diligence, there is no better way than to analyze Defective IPOs as case studies and elicit lessons from past mistakes. This Hontex Case Study will be the first of many to come as my contribution to our capital market industry in Malaysia to uplift our professional skills and ethics.

On 20 June 2012, Hong Kong’s Court of First Instance, in a landmark case, ordered Hontex Holdings Company Limited (Hontex) to pay back more than HK$1billion (USD133m) to IPO investors for issuing a prospectus containing false and misleading information.

Hontex was listed on the Stock Exchange of Hong Kong on 24 December 2009. Its two wholly owned subsidiaries which are also parties to the proceedings are Easy Venture International Limited and First Heritage Limited.

Hontex was ordered under Section 213 of the Hong Kong Securities & Futures Ordinance (SFO) to:

1. make a repurchase offer to investors who subscribed for Hontex shares in the initial public offering or purchased them in the secondary market.

2. pay a further sum of $197,755,503 into the Court within 28 days, adding to the amount of $832,244,497 already frozen under the interim orders.

3. convene a shareholders’ meeting to approve a resolution and then, upon approval, to take steps to repurchase the shares allotted to or purchased by approximately 7,700 public shareholders who are currently holding Hontex shares.

The repurchase scheme was managed by Court appointed administrators. Hontex shareholders were given the choice whether to approve the repurchase scheme and, if it is approved, whether to accept or reject the repurchase offer.

See: https://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=12PR63

What went wrong?

In a statement of agreed facts provided to the Court, Hontex has acknowledged that it was reckless in allowing materially false and misleading information to be included in its prospectus which induced investors to subscribe and purchase its shares and that it contravened section 298 of the SFO.

Hontex, a Chinese fabric maker, acknowledged that:

1. the turnover amounts stated in its IPO prospectus in for the years ended 31 December 2006, 2007 and 2008 were materially false and misleading as was its profit before tax;

2. the value of its cash and cash equivalents for the years ended 31 December 2007, 2008 and 30 June 2009 were materially false and misleading; and

3. the number of franchise stores disclosed in the IPO prospectus, as at 31 December 2008 and 8 December 2009, was also false and misleading.

Hong Kong’s Securities & Futures Commission (SFC) alleged that Hontex’s IPO Prospectus overstated:

1. Group turnover for the years ended 31 December 2006, 2007 and 2008 by approximately RMB 380,934,125, RMB 708,894,820 and RMB 974,733,321 respectively;

2. profit before tax in the same financial years by approximately RMB 102,935,289 RMB 185,001,887 and RMB 298,286,785 respectively;

3. cash and cash equivalents held by the company for the years ended 31 December 2007, 2008 and 30 June 2009, by approximately RMB 66,629,463, RMB 165,262,910 and RMB 204,536,101 respectively; and

4. the number of franchise stores as at 31 December 2008 and 8 December 2009 by 8 and 37.

In admitting a contravention of section 298, neither Hontex nor its directors and the other defendants admitted any criminal contravention of this provision nor can they be taken to have done so.

Hontex did not agree to the extent of overstatements alleged by the SFC because it cannot verify the true position, but has accepted that figures in the IPO prospectus were materially false.

The impressive Section 213 of the SFO armed the SFC with a powerful tool to act “as protector of the collective interests of persons” who have been injured by misconduct. The SFC was able to apply for court orders without there first being a finding of market misconduct, including injunctions and a range of remedial orders.

Who else got punished?

The SFC also revoked Hontex’s IPO Sponsor Mega Capital (Asia) Company Limited’s (Mega) licence to advise on corporate finance and fined it $42 million for failure to discharge sponsor’s duties in relation to Hontex’s listing application after investigating Mega’s practices and procedures in acting as the sole sponsor.

The SFC’s main findings of Sponsor failures are as follows:

1. Inadequate and sub-standard due diligence work

(1) Assessing the authenticity of business performance requires proper due diligence on customers, suppliers and franchisees but Mega’s due diligence work was inadequate and sub-standard;

(2) material information (like transaction figures with the Group) was missing from questionnaires that Mega completed with suppliers and customers;

(3) Mega failed to follow-up on missing information;

(4) a number of interviews with suppliers and customers were conducted over the phone last minute on the day that Hontex filed its listing application;

(5) franchisees information provided by Hontex (name, address and turnover of each franchisee) was not properly verified; and

(5) transaction records between franchisees and the Group were not obtained.

2. Failure to act independently and impartially

(1) Important aspects of Mega’s due diligence work on Hontex’s suppliers, customers and franchisees were sourced from Hontex without independent scrutiny, showing inappropriate reliance on the issuer;

(2) Mega acceded to Hontex’s request that it should not approach the Group’s suppliers, customers and franchisees directly;

(3) All interviews were arranged by Hontex and conducted in the presence of Hontex’s representatives;

(4) Mega also accepted Hontex’s representation, without any inquiries, that some of its suppliers/customers refused to have face-to-face interviews with Mega;

(5) Mega accepted the arrangement to have telephone interviews with such suppliers/customers arranged by Hontex; and

(6) Written confirmations (of independence from Hontex) from franchisees were obtained through Hontex.

3. Inadequate due diligence audit trail

(1) Mega did not adequately document their due diligence planning and significant aspects of their due diligence work; and

(2) No records showing what background or other due diligence searches had been conducted by Mega on the suppliers, customers and franchisees of the Group.

4. Inadequate staff supervision

(1) Most of the due diligence work was handled by junior and inexperienced staff without adequate supervision; and

(2) Each of the two responsible officers of Mega who were the sponsor principals in relation to Hontex’s listing application denied that they were responsible for the listing application.

5. Breach of sponsor’s undertaking and filing untrue declaration with The Stock Exchange of Hong Kong Limited (SEHK)

(1) As sponsor, Mega submitted an undertaking and a declaration to SEHK on 23 July 2009 and 15 December 2009 respectively, confirming that Mega would/had made reasonable due diligence inquiries and believed that all information provided to the SEHK during the listing application process of Hontex, including the information contained in the IPO Prospectus, was true in all material respects and did not omit material information;

(2) In view of failures and deficiencies of due diligence work identified, Mega was found to have breached the undertaking given and sanctioned by the SFC.

See https://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=12PR39

The Whistleblower and related investigations

If not for an accounting firm whistleblower, the SFC would have been clueless about the shenanigans at Hontex until it was too late.

The accounting firm conducted internal investigations and reported the matter to Hong Kong’s Independent Commission Against Corruption (ICAC) resulting in bribery charges against a senior manager of the accounting firm who helped to prepare the Hontex IPO Prospectus. Those accounting statements were later found by Hontex’s Internal Auditors Committee to be unreliable.

Allegations of attempted bribery of the accountants by Hontex’s Consultant and the judge’s acquittal of the senior manager due to reasonable doubts arising from the unreliable testimony of his superior are compulsory reading for accountants and other experts involved in IPOs on what constitutes appropriate professional and ethical behavior for experts and professionals involved in IPOs.

See

http://www.scmp.com/article/966392/kpmg-auditor-acquitted-bribery-counts

https://webb-site.com/dbpub/natarts.asp?p=57413

Key Lessons

The drastic consequences for defective IPO prospectuses and the sanctions meted out against Hontex and Mega, and the accountant’s narrow escape from bribery conviction are sobering indeed.

Hontex and Mega’s inadequate due diligence work and the accountants harrowing experience are also invaluable lessons for our capital market industry participants in Malaysia.

The SFC’s innovative use of Section 213 to preserve IPO proceeds in Hong Kong before they are transferred or dissipated abroad where it will be harder to enforce Hong Kong’s laws and regulations has recently been extended beyond normal principal targets (such as former directors) to co-sponsors and former auditors as additional defendants in the China Forestry Holdings case.

In Malaysia, our Securities Commission (SC) is similarly armed with wide powers under Section 360 of the Capital Market And Services Act.

In an appropriate case, there should not be any doubts that the SC will NOT hesitate to use Section 360 “as protector of the collective interests of persons who have been injured by misconduct.”